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3232A Macroeconomic Theory of the Open

Economy

Figure 1 The Market for Loanable Funds

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Quantity ofLoanable Funds

RealInterest

RateSupply of loanable funds

(from national saving)

Demand for loanablefunds (for domesticinvestment and net

capital outflow)

Equilibriumquantity

Equilibriumreal interest

rate

Figure 2 The Market for Foreign Currency Exchange

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Quantity of Pounds Exchangedinto Foreign Currency

RealExchange

RateSupply of pounds

(from net capital outflow)

Demand for pounds(for net exports)

Equilibriumquantity

Equilibriumreal exchange

rate

Figure 3 How Net Capital Outflow Depends on the Interest Rate

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0 Net CapitalOutflow

Net capital outflowis negative.

Net capital outflowis positive.

RealInterest

Rate

Figure 4 The Real Equilibrium in an Open Economy

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(a) The Market for Loanable Funds (b) Net Capital Outflow

Net capitaloutflow, NCO

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign Currency Exchange

Quantity ofPounds

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

Supply

Supply

Demand

Demand

r r

E

Figure 5 The Effects of Government Budget Deficit

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(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign Currency Exchange

Quantity ofPounds

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

Demand

Demand

r2

NCO

SS

S S

r2B

E1

r rA

1. A budget deficit reducesthe supply of loanable funds . . .

2. . . . which increasesthe real interestrate . . .

4. The decreasein net capitaloutflow reducesthe supply of poundsto be exchangedinto foreigncurrency . . .

5. . . . which causes thereal exchange rate toappreciate.

3. . . . which inturn reducesnet capitaloutflow.

E2

Figure 6 The Effects of an Import Quota

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(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofPounds

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

r r

Supply

Supply

DemandNCO

D

D

3. Net exports,however, remainthe same.

2. . . . and causes thereal exchange rate to appreciate.

E

E2

1. An importquota increasesthe demand forpounds . . .

Figure 7 The Effects of Capital Flight

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(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofPesos

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

r1 r1

D1

D2

E

Demand

S S2

Supply

NCO2NCO1

1. An increase in net capitaloutflow. . .

3. . . . which increasesthe interestrate.

2. . . . increases the demandfor loanable funds . . .

4. At the sametime, the increasein net capitaloutflowincreases thesupply of pesos . . .

5. . . . which causes thepeso todepreciate.

r2 r2

E